In the normal course of business, when you sell a property that has appreciated in value, the gain is subject to federal capital gains taxes according to the Internal Revenue Code as well as subject to state capital gains taxes pursuant to individual state tax laws. The sale of an asset may also be subject to depreciation recapture tax. Both of these potential tax obligations can be deferred if the transaction qualifies for a 1031 exchange.
Capital Gain Tax Rates
As with most tax rates, the rate at which the federal government taxes capital gains fluctuates and is dependent on the personal income tax bracket of the individual or entity selling the property. For 2011, for example, the maximum capital gains tax rate was 15 and 28 percent for real property and collectibles respectively. Imagine that you purchased real property ten years ago for $100,000 and sold it in 2011 for $200,000. If you are subject to the maximum capital gains tax, therefore, you would owe 15 percent capital gains taxes on the gain, or $15,000, in federal taxes. Additional state capital gains taxes would also potentially apply on top of the federal capital gains taxes due.
Recaptured Depreciation
The depreciation recapture tax rate can also fluctuate but is typically equivalent to the income tax rate of the individual or entity selling the asset because the gain is viewed as income. Depreciation recapture tax applies when an asset is sold for more than the value of the asset after depreciation has been taken. For example, imagine that you purchased a piece of business equipment five years ago for $25,000. The total depreciation deduction to date is $20,000, making the current value $5,000. If you sell the equipment for $10,000, the difference, or $5,000, is subject to depreciation recapture tax.
Deferred Gain
By entering into a 1031 exchange transaction, the deferred gain essentially amounts to gaining an interest free loan from both the federal and state government. The deferred gain funds that you would otherwise use to meet your tax obligations can be re-invested in the replacement property and used, interest-free, until you sell the replacement property.
As with any transactions, there is a potential downside to entering into a 1031 transaction. Because tax rates are subject to change, there is always the risk that the current capital gains tax rate at the time you eventually do pay the tax will be higher than it is at the time you enter into the 1031 exchange. In addition, in order to take full advantage of a 1031 exchange, the property in which you re-invest should ideally appreciate in value. If the replacement property fails to appreciate in value, then your 1031 exchange “interest-free loan” does not result in any additional gain, making the deferral of the original gain unproductive from an investment standpoint.
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We Can Help
Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.
